Searching For A Bargain: Where Contrarians Look After A Multi-Year Bull Market
- International markets and valuations versus North American markets and valuations.
- A brief review of beaten up sectors in America along with potential risks and rewards.
- A brief review of contrary Canadian sectors along with potential risks and rewards.
Twice a year I conduct a screen of North American indexes and a top to bottom review of the existing watch list for Contra the Heard. Though valuations are relatively high, and many industries are near multi-year highs, investors should remember that the stock market is a market of stocks, and there are generally beaten up countries, sectors, or companies out there somewhere.
The goal of the screen is to identify unloved and, hopefully, undervalued opportunities that may be worth further scrutiny. After the latest review, the watch list included 443 US companies, 156 Canadian names, and 52 ETFs. Of those, there is a shortlist of 19 US names, 16 Canadian stocks, and 9 ETFs that I’ll continue to watch closely or research. My hope is that a few of these will make good portfolio candidates in the future.
Before reading further, keep in mind that I will not be discussing in detail the individual securities found during the screening process. Instead, this article will provide a broad overview of the countries, industries, and sectors where many contrary opportunities were found.
International Versus North American Valuations:
Unfortunately for most American investors, prices are high versus historic norms and other countries.
Source: Star Capital’s February 28, 2019 Stock Market Valuation Table
According to Star Capital, the United States is among the world’s most expensive countries, along with India, Denmark, Ireland, and Belgium. Canada’s valuations are in the middle of the pack along with Hong Kong, France, and Taiwan. Today, the most undervalued markets include Turkey, Russia, China, Hungary, Singapore, and Italy.
Investing in these relatively undervalued countries may be rewarding but it is not for the faint of heart. Russia and China rarely make the news for their good behaviour. Both countries are also prone to corruption. This may cast doubt over the validity of corporate earnings, underlying stock valuations, and the reliability of economic data. Add on the fact Russia faces Western sanctions and perhaps the valuations are justified. In China, the government faces a slowing economy, ghost city driven malinvestment, and trade tensions with the US so maybe it is too soon to get seriously interested.
Turkey seems cheap too but is still recovering from the collapse of the Lira last year and faces structural economic challenges. Hungary, Singapore, and Italy aren’t issue-free either. In Italy’s case, national debt to gross domestic product is 132%. The country has an unemployment rate over 10% and is dogged by declining demographics. Still, a low price is a low price.
For retail investors, accessing overseas markets can be difficult. ADRs, ETFs, and mutual funds offer imperfect and somewhat expensive ways to generate international exposure. Fortunately, competition in the exchange traded space appears to be driving down cost and increasing the options North American investors have to choose from when considering overseas markets.
Here at Contra the Heard, we are looking at some of these places to try to determine if the bad news is baked in. Though there are many ETFs on the watch list which follow these geographies, a few ETFs which track these countries specifically are:
- iShares China Large-Cap ETF (NYSEARCA:FXI),
- Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR)
- iShares MSCI Italy ETF (NYSEARCA:EWI)
- VanEck Vectors Russia ETF (NYSEARCA:RSX)
- VanEck Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ)
- iShares MSCI Singapore Capped ETF (NYSEARCA:EWS)
- iShares MSCI Turkey ETF (NASDAQ:TUR)
Beaten Down Sectors in the US:
America is hot versus global peers, but there are a handful of segments and sub-sectors with low valuations. A good proxy for where to find these opportunities is to glance at a sectoral breakdown:
Source: Guru Focus
This quarter’s screen confirmed Guru Focus’s breakdown. Energy remains littered with dozens of downtrodden companies; this may be for good reason though. Many in oil and gas carry huge debts and the industry is faced with a difficult macro environment. On the supply side, each time OPEC cuts production the Permian eats their lunch. On the demand side, the industry is being stalked by electric and hybrid cars as well as fears over how to address climate change.
Coal mining, solar manufacturing, and shipping are other subsectors that regularly show up on our watch lists, but they are generally debt heavy too. Although the Trump administration has attempted to help coal, the ebb tide is strong with coal plant retirements back near all time highs. As coal declines, solar is on the rise. One ETF I have watched as a proxy for the solar industry is the Invesco Solar Portfolio ETF (NYSEARCA:TAN).
On the one hand, investing in heavily indebted companies and sectors presents investors with the risk of bankruptcy and significant capital loss. On the other hand, investors can receive handsome payoffs if a corporation survives and returns to form. This is because the returns on equity end up looking great. ETFs, like the Invesco Solar Portfolio ETF, serve as a way to reduce this debt risk and diversify but they cannot eliminate it.
Retail is another area where one may find the unloved. Retailers of all stripes appeared this time around – from watches and women’s clothing to discount stores and home furnishings. Unlike oil and gas, retail has many names with clean balance sheets. Careful selection is critical, however, as the Amazon tsunami shows no signs of letting up.
I was not surprised to see oil, gas, and retail during this review process, but I was surprised by the number of auto-part companies, specialty chemical manufacturers, and medical equipment providers. As these fields are relatively new to me, I don’t have a good sense of what is driving this yet.
Finally, financials continue to populate the watch list even though we are a decade out from the Financial Crisis. For a more detailed discussion on financials, please see a previous post here: Introspection Is Key: Assessing Past Regional Bank Trades And Their Post-Sale Performance.
Many stocks end up on our watch list because of an industry wide downturn, but others end up here without being caught up in a sectoral downdraft. These companies come from nearly anywhere you can imagine. Often, they end up on our list of unloved entities because they have run into some sort of issue with their pricing power, their balance sheet, or their growth trajectory. Other times they are engaged in a protracted turnaround or are once-darling stocks that have failed to live up to high expectations. Sometimes corporations end up on our watch list for simple and sad reasons like losing a founder or good CEO to an unexpected health issue.
Contrary Canadian Sectors:
Unlike the US which is well balanced between many sectors, Canada is dominated by financials, energy, and materials, which is predominately made up of mining companies.
Source: Standard & Poor’s Dow Jones Indices, S&P500, and Toronto Stock Exchange Composite
As in the US, the Canadian energy sector is littered with outfits that have debt-heavy balance sheets. To make matters worse, Alberta’s oil market is hammered by pipeline capacity constraints and ongoing issues building new pipelines. Though there are many other factors at play, these problems contribute to a material discount between Western Canadian Select and West Texas Intermediate. This discount has narrowed since the Alberta government engaged in an OPEC like production cut, but the province and its energy companies remain in a tough spot.
While mining companies often have better debt metrics than their oil and gas counterparts, dilution can be a problem. This is especially true for miners in the exploration and development phase. We tend to avoid exploration miners and try to focus on producers who have a strong operating history, limited dilution, and a good mineral deposit base. One such name that fits these criteria and which I have written about before here on Seeking Alpha is Alacer Gold (OTCPK:ALIAF). Those who are interested can read that article here: Alacer Gold: Sulphide Project Completed On Time And Under Budget.
In addition to energy and mining, many forestry, milling, and paper producers appeared on the screen. A handful of Canadian media providers made the list too. Many of them have had their business models destroyed as printed papers, ad dollars, and paid subscriptions services continue their multi-year decline in the wake of social media and internet search giants. Some media organizations also have significant intangible assets and goodwill on their balance sheets. Back before the internet cut into their business, when revenues were growing and cash flows were strong, these intangibles could be justified. That is not the case today. Many companies have written off a lot of goodwill over the past decade, but one could argue there is still a long way to go.
Income oriented Canadian investors may also be interested in preferred shares which appear contrary. Three ETFs which follow the Canadian preferred share universe are:
- BMO Laddered Preferred Share ETF: ZPR on the TSX
- Horizons Active Preferred Share ETF: HPR on the TSX
- iShares S&P/TSX Canadian Preferred Share ETF: CPD on the TSX (CYSXF Analysis & News - iShares S&P/TSX Canadian Preferred Share Index ETF)
I sometimes purchase individual preferred shares personally, but I have never bought a preferred share ETF and we have not invested in preferred shares for either portfolio at Contra the Heard. This is because volumes are low, the Canadian preferred share market can be very volatile, and assessing these securities adds another layer of complexity. While preferred shares can offer income and currently look low, the securities are not a free lunch and we tend to approach them with caution.
Despite the multi-year bull market and relatively high valuations, there are several countries, sectors, and companies out there that are beaten up, unloved, and – hopefully – undervalued. However, we also need to remember that downtrodden securities are often priced that way for a reason. As contrarian investors, we try to proceed carefully. This requires lots of homework and patience, as well as weighting portfolio additions appropriately when a security is purchased. Even then, it doesn’t always work out, and sometimes investments go south. Now that this latest watch list review is complete, the next goal is to focus on a handful of names, understand the risks and the rewards around these opportunities, and find those stocks that can perform well.
While we are bottom up investors, we keep the macro picture in the back of our minds. In addition to the high relative valuations globally, volatility remains low, and debt levels are high. This includes consumer and mortgage debt here in Canada, corporate debt elsewhere, and all types of debt globally. Unfortunately, valuations and debt loads are terrible timing tools. What forward-looking value they have is confined to determining the potential magnitude of future downturns or rallies when a sea change occurs. Bond market activity can be a somewhat better timing tool, and with yields inverting there are plenty of warning signs afoot. At Contra the Heard, our solution to this macro outlook is to try and pick cheap securities, bet size appropriately, and maintain dry powder.
The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.
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